Hedge funds to face challenging year ahead

By

Darren Stubing

PublishedSunday, January 06, 2008

Following a challenging year in 2007 with many hedge funds experiencing significant return volatility, with some funds reporting large losses and being wound up, while others restricted investment withdrawals, hedge funds in 2008 will face similar challenges in chasing market alpha.

Despite the problems faced by a number of hedge funds in 2007, and the associated headlines, the overall performance of the sector was quite respectable. For the full year, the return on the Credit Suisse Tremont Hedge Fund Index was approximately 12 per cent.This was higher than most main global indexes. The Dow Jones World Index rose by 10 per cent year on year, while the Dow Jones Total Market Aggregate Index rose by six per cent in 2007. The S&P 500 was also up by six per cent last year. The MSCI World Index gained 7.1 per cent in 2007.

A number of hedge funds in 2007 came under severe pressure in 2007. These included those managed by market luminaries such as Goldman Sachs, Renaissance Technologies and Bear Stearns. Goldman Sachs’ Global Equity Opportunities fund suffered significantly as global markets sold off on worries about debt and credit. The fund saw its value plunge amid market volatility. Goldman Sachs subsequently led a group of investors to help bail out the hedge fund, which relies on computer-driven trading strategies.

Bear Stearns and BNP Paribas’ hedge funds were hammered by the credit market crisis. Bear Stearns disclosed two of its multi-billion dollar hedge funds were wiped out because of heavy bets on mortgage-backed securities. BNP Paribas froze three funds invested in US asset-backed securities.Quantitative funds in 2007 that rely on computer models to make investments took a beating because of triple-digit swings on Wall Street during certain periods.Drake Management limited withdrawals from its flagship hedge fund after investors in the high-flying New York-run fund – one of the best performing in previous years – tried to pull out almost $1 billion (Dh3.67bn) at one point.

Failed hedge funds included Basis Yield Alpha, run by Australia’s Basis Capital. Although statistical arbitrage managers faced specific difficulties in 2007, often linked to the US sub-prime mortgage crisis and subsequent credit market conditions, most strategies recorded good performances last year. Some returns were spectacular. One of the best performing hedge funds was Paulson Capital, whose early bet on trouble in the sub-prime mortgage sector paid off substantially. Paulson Credit Opportunities I fund was up by more than 500 per cent during 2007.

Sub-strategies that performed well in 2007 including emerging markets, rising by 19 per cent, global macro, which rose by 16 per cent,and long short equity and event driven strategies.

Where do hedge fund managers believe the best returns will be found in 2008?Distressed event drive strategy is considered to have good potential in 2008 after recording returns of around eight per cent in 2007. Other strategies likely to perform well again in 2008 include global macro and long short equity. Although emerging markets are expected to be a solid performer this year, returns are unlikely to match those of 2007.

Global macro strategies bet on movements of currencies, sovereign debt and other instruments. Long short equity strategies bet on rises and falls in stock prices and is the dominant approach in the industry. Distressed investors, who typically invest in high yield bonds and other credits, are likely to benefit on the short side, with a long-expected pick-up in defaults among lower-rated securities.

After the start of the credit crisis in 2007 caused by the US sub-prime meltdown, and after subsequent turbulence in equity and bond markets, a number of funds of hedge funds turned to distressed investing, a cyclical strategy that tends to do well when times are tough for everyone else. Distressed funds look to buy the discounted bonds, loans or other debt of firms that have defaulted on debt payments or are set to enter bankruptcy or financial restructuring and bet they can weather the storm and earn strong returns from a turnaround.

Rating agencies predict that the global high yield bond default rate is likely to quadruple to around four per cent by the end of 2008 from a 26-year low of one per cent at end 2007. The four per cent estimate may be pessimistic but there is no doubt that defaults will rise in the second half of 2008.

Hedge fund managers in 2008 will also look for answers in terms of when the housing market will hit bottom and how that will impact consumers and the global economy, as well as where mortgage securities are priced relative to the housing market. Bank exposure, both long and short, will also remain important for hedge funds as they look for arbitrage opportunities. Due to the diversification features of hedge funds and alternative investments, this asset class will remain in great demand in 2008.